India's economic growth languished near its slowest in three years in the quarter that ended in June but was slightly better than expected, signalling the worst may be over for Asia's third largest economy and dashing investor hopes of an early rate cut.

India's quarterly GDP grew 5.5 per cent, driven by a rebound in construction and financial services, provisional government data showed on Friday, just above the 5.3 per cent posted in the three months ended in March and slightly higher than economists had forecast in a Reuters poll.

The number offered little respite for Prime Minister Manmohan Singh as he struggles to escape a series of political scandals that have paralysed his economic agenda. Economists do not foresee a rapid return to boom times in India.

While failing to signal a decisive rebound, the read-out was viewed by analysts as not weak enough to prod the central bank to make a near-term cut in interest rates, which have been on hold since April as it tries to force the government to push through reforms that would help tame inflation.

"We expect a gradual recovery in growth during the current fiscal year ending in March 2013, but this recovery is contingent on structural reforms," said Leif Eskesen, chief economist for India and ASEAN at HSBC in Singapore. "It will also depend on the stabilisation of the global economy."

Weak demand in the West has hit Indian exports, but the heaviest toll on the economy is from government overspending and a lack of reforms, a point made by both the central bank and ratings agencies Fitch and Standard & Poor's, who threatened to downgrade India's sovereign ratings to junk.

NO RATES MOVE, YET

Many G20 central banks have been moving to support growth, but Indian policy interest rates have come down just once in more than two years and are among the highest of big economies.

Some investors had been optimistic that a weak growth number would persuade the Reserve Bank of India (RBI) to cut borrowing costs at its September 17 review, but the slight uptick will bolster the bank's argument that stubborn inflation is its main concern.

"The RBI still maintains a hawkish bias and rate cuts still seem some way off," said Jonathan Cavenagh, a currency strategist at Westpac Bank in Singapore, who said data from across Asia suggested growth would remain subdued in the September quarter.

RBI Governor Duvvuri Subbarao this week said inflation remained too high and needed to fall further or risk more damage to the economy.

India's benchmark 10-year bond yield gained 5 basis points to 8.24 per cent after the GDP data, while one- and five-year overnight index swap rates rose 5 basis points each, reflecting disappointed hopes for rate cuts.

Singh's economic advisory panel this month cut its forecast to 6.7 per cent for economic growth in the year to next March (2012-13), down from a previous forecast of 7.5-8 per cent. The RBI predicts growth of 6.5 percent in the same period.

While the GDP figure is strong by global standards, it is considered almost recessionary in India, which targets 9 percent expansion to provide jobs for a bulging young population.

Persistent economic sluggishness was reflected in data on Friday that showed infrastructure output grew 1.8 per cent in July from a year earlier, slower than annual growth of 3.9 per cent in the previous month.

Worried about social unrest if aspirations are not met, Singh recently called high growth a matter of national security.

But for all the gloom in recent months, plenty of companies and investors continue to bet on India's longer-term prospects, especially in sectors driven by domestic demand.

Net foreign institutional investment in Indian stocks and bonds has quadrupled this year to $16.7 billion, including nearly $4 billion since the start of July.

The BSE Sensex is up more than 12 per cent this year, making it one of the best performing major markets in Asia.

BUDGET CUTS?

Newly reappointed Finance Minister P. Chidambaram has vowed to revive an economy he steered through the 2008 credit crunch with tax cuts.

The buzz on his return to the ministry helped a market rally, further fuelled by a flurry of minor policy moves.

On Friday, he said the decline in fixed investment growth to 0.7 per cent in the quarter, from 14.7 per cent a year earlier, was a concern: "It emphasises once again the need to take quick decisions to accelerate investments, especially removing all bottlenecks to investments in the manufacturing sector."

Stung by S&P's warning India may become the first country in the BRICS group of big emerging markets to lose its investment grade rating, Chidambaram's ministry is also contemplating possible budget cuts later in the year.

More far-reaching economic reforms remain elusive, however, and the government is distracted by a scandal over the allocation of coalfields that has paralysed parliament.

Singh, the pilot of India's initial reforms as finance minister in the early 1990s, is committed to slashing budget-busting subsidies on diesel and other fuels but struggles to find a good time to make such a politically sensitive move.

A plan to allow foreign supermarkets to sell to India's 1.2 billion people is also bogged down by politics, with many in Singh's own party opposed to a policy they say will hurt small shopkeepers.

He has a window to implement unpopular economic policies after the parliament session finishes next week and before elections in the state of Gujarat towards the end of the year, but a drought driving up farm aid casts doubt on that timetable.

India's manufacturing sector grew an annual 0.2 per cent during the quarter, the first of the 2012/13 fiscal year, while farm output rose 2.9 per cent.

Construction grew a surprisingly strong 10.9 per cent while the financial services sector was up 10.8 per cent, possibly a result of a 50 basis point rate cut made by the central bank in April.

Some economists expressed surprise that industrial figures were in positive territory because industrial output data has shown a series of contractions since March. India often steeply revises economic data, raising questions about its reliability.

Recently revised GDP data shows a much worse economic performance than originally thought in the aftermath of the global financial crisis.